Edgewater Technology Corp. (EDGW)  

Summary

Our fund generally focuses on smaller companies with “Ft. Knox” balance sheets and large and sustainable free cash flow yields.  We are often seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.

Edgewater Technology (EDGW) is an under-valued IT services company that provides advisory and product-based consulting services to its highly diversified client base.  EDGW trades at about 60% of revenues, 6x adjusted EBITDA, and a 13% unleveraged free cash flow yield.  Importantly, EDGW has an unleveraged balance sheet, with a large net cash position (25% of market cap) that we believe can continue to grow over time (absent share buybacks or “tuck-in” acquisitions). 

We previously wrote up EDGW on VIC in early 2012 at about $2.80 per share and exited our position at about $6 per share.  However, we believe the company has continued to build shareholder value and that the current stock price does not reflect the value inherent in the business.

EDGW has shifted its focus in recent years to product-based consulting services whereby they implement Oracle, Microsoft, and other software with a focus on upper to middle global 2000 companies.  We continue to believe EDGW is an important partner for these major software vendors, who rely on EDGW to implement their software and interact with end-user customers.  We believe there will be continued solid demand for this software and for EDGW’s services.  We also like that EDGW’s revenues are well-diversified, with its five top customers representing only 16.5% of total service revenue, and only one customer representing more than 5% of revenues in Q2 of 2014.  We believe the product software which EDGW deploys improves processes, reduces costs, and increases revenues for the upper middle market and Global 2000 companies that represent its target market. 

EDGW has about 12m shares outstanding trading at about $7 per share for a market cap of about $84m.  EDGW had net cash of about $22m (or about 25% of market cap) as of 6/30/14 for a total enterprise value (EV) of about $62m.  LTM revenues are about $110m and LTM adjusted EBITDA is about $10m.  LTM free cash flow (cash from operations less capital expenditures) is about $9m.  We believe EDGW can sustainably generate $8m to $9m of FCF or an unleveraged FCF yield of about 13%.  We believe EDGW’s adjusted EBITDA could grow to $12m in 2016, with a net cash position of $35m by year end 2016.  We think with EDGW’s asset light business model and the current low interest rate climate, EDGW could trade for 10x adjusted EBITDA plus $35m of net cash at the end of 2016 or a market value of about $155m or $13 per share (as compared to $7 per share today, or about 85% higher).

EDGW is expected to announce Q3 results on Wednesday, October 29, 2014.  While we are hopeful results will be solid, we have no special insight here, there can be significant variability in quarterly results, and investors should take a long term view.

Business Description

EDGW was previously focused on custom building of software for its customers but has morphed into a channel focused player.  Management believes that the custom building aspect of the software industry is moving overseas to lower cost locations and the customers today want a “one-stop” shop approach, with Oracle and Microsoft software off the shelf.  Over 80% of EDGW’s current revenues are channel related with Oracle and Microsoft as compared to about 30% in 2007.  EDGW provides services under the following brands: (1) Edgewater Technology provides business advisory and technical consulting services to clients in implementing  projects that provide a high rate of return; (2) Edgewater Ranzal is a recognized expert in EPM product based consulting in the Oracle Hyperion channel; and (3) Edgewater Fullscope is an award winning Microsoft Dynamics AX and CRM partner that provides product-based ERP services for manufacturers.  Based on LTM results, about 51% of EDGW’s revenue was from the Oracle channel, 36% of revenue was from Microsoft channel, and 13% was from Classic consulting.

We believe EDGW is one of Oracle’s top five IT service provider partners in North America and a leading service provider for Microsoft’s Dynamic CRM software in the U.S.  EDGW has strategic alliances with Oracle, Adobe, Webtrends, Microsoft, IBM, Informatica, Google, OpenText, and others.  These alliances generally entail sharing sales leads, joint marketing efforts, making joint customer presentations, and negotiating discounts on license fees or other charges.

ERP work is generally for about 6 to 12 month periods and includes larger projects that represent the backbone of the customer’s entire IT infrastructure.  EDGW is primarily focused on ERP through the Microsoft Dynamics AX product, which is oriented toward manufacturing companies.  EPM software is business intelligence software which provides enhanced information which makes the customer more efficient.  EPM work is generally 3 to 6 months and is primarily in the Oracle channel with its Oracle Hyperion EPM solution.  We believe that almost 50% of EDGW’s sales leads come directly from its software vendor partners and EDGW often makes the sales pitch with them.

EDGW had 407employees (excluding contractors) at December 31, 2013, of which about 75% were billable consultants. EDGW has a large North America footprint and has established a presence in the U.K. in recent years.  EDGW provides a range of services to its customers under three basic categories: (1) business advisory services (business strategy, best practices, and transformational change); (2) product based consulting (enterprise performance management or EPM, enterprise resource planning or ERP, and customer relationship management or CRM); and (3) technology consulting (architecture, roadmaps, analysis and design, custom development, web solutions, etc.)  EDGW generates attractive revenue per consultant, which is a key performance measure, with service revenue per consultant of $261k in 2005, $300k in 2007, $340k in 2008, $348k in 2009, $324k in 2010 and $335k in 2011, $354k in 2012, and $358k in 2013.

EDGW acquired Fullscope (Dynamics AX ERP) in December 2009 for $15m in cash plus earn outs and Meridian Consulting International (Oracle HSF) in May 2010 for $1.8m plus earn outs, in order to strengthen its product based solutions.  EDGW also internally developed IP assets (Dynamics AX Chemical Accelerator).  Over the past six years, EDGW has invested in multiple acquisitions to build out its current business model. 

We believe EDGW’s product-based business model is significantly stronger than the custom software oriented business model which dominated revenues going into the 2008-9 recession.  We also believe EDGW’s client base is more highly diversified than in 2008-9, when EDGW lost some large clients which significantly impacted revenues.

EDGW has consistently generated strong FCF over the past six years, despite the difficult economy.  From 2008 to 2013, cumulative cash from operations was about $30m, or about 45% of today’s EV.  Even in the recession of 2008-9, cash generation did not go negative.

EDGW has an asset-light business model. EDGW has limited fixed assets and its net working capital investment is modest, as receivables are significantly offset by accounts payable.  Consequently, EGDW has a business model with ROIC well over 50%.  EDGW’s primary asset is its employees and the Company had close to 400 employees at 6/30/14.

EDGW has a broad range of customers and specializes in several verticals, including manufacturing (Cognex, Sanimax, Kraco, Bausch Lomb), healthcare (Baylor Health Care Systems, Miami Children’s Hospital, Moffitt Cancer Center), insurance (Trustmark, Horace Mann, Delta Dental), hospitality (Extended Stay, Hilton, Carnival), retail (Michaels, Motorcoach, Autonation), financial services (Blackstone, Fidelity Investments, Mastercard), utilities/mining (Newmont, ), and emerging (Lennox, Acxiom, Fluror, Iron Mountain).  During 2013, EDGW recorded revenue from 387 customers (of which 92 were new customers) as compared to revenue from 394 customers in 2012 (of which 103 were new customers).

We believe EDGW is continuing to benefit from a strong technology upgrade cycle in product including ERP and EPM.  We continue to believe that expenditures in these areas have been deferred and customers are now in a “catch-up” mode.  We believe the end-user customers receive attractive ROIs and efficiency benefits from these software solutions and this should continue to help drive EDGW’s services business over the next few years.

Operating Costs

EDGW operates a service business and, as such, the primary components of the company’s cost structure are labor-related expenses.  We believe that if a revenue slowdown occurs, due to recession or reduced demand for the software modules which EDGW is focused on, that the company could right-size its cost structure to match current revenue levels relatively quickly. Only about 5% of EDGW’s service revenues are from fixed price contracts while over 90% of service revenues from time and materials contracts.

Strong Cash Flow Generation and Solid Business Model

EDGW has a solid business model with limited capital expenditures and working capital requirements.  EDGW’s business has a high ROIC of 50% based on FCF divided by the sum of net working capital plus net PPE.  Management believes that adjusted EBITDA is a good proxy for FCF.  LTM adjusted EBITDA is close to $10m.  We think adjusted EBITDA could grow to $12m in 2016.  Based on $12m of adjusted EBITDA in 2016 and about $10m of FCF, we would expect EDGW’s net cash position to grow to $35m by year-end 2016.  Capital expenditures over the past few years have averaged less than $1m per year.  Working capital needs have been modest.  EDGW has a gross NOL of about $45m which should result in minimal cash taxes for the next few years.  Over the past three years, from 2011 to 2013, EDGW has generated cumulative FCF of close to $20m or about one-third the current EV.

Strong Relationships with Software Vendors and End-User Customers Provide a Strong Competitive Position

We think EDGW’s well established relationships with major software vendors Oracle and Microsoft and others and its employees’ detailed knowledge and experience in specific verticals with these software products are an important competitive advantage.  EDGW is a top IT service provider for both Oracle and Microsoft.  Software vendors do not want to deal with several different systems integrators and this favors EDGW’s scale.  Also, EDGW’s highly diversified customer base – top 5 customers are about 16.5% of service revenues – is also valuable, since the large software vendors depend on companies like EDGW to sell and implement their software systems, especially to small and middle market companies, and organizations.

EDGW’s industry expertise has also led to intellectual property creation and monetization, as EDGW has been successful in developing proprietary software customized to the verticals which it serves.  This IP software is deployed on top of the basic Oracle and Microsoft ERP and EPM modules.  This further cements its relationships with end user customers and with its powerhouse software vendors.

EDGW’s experienced consultants have an average tenure with the company of about five years and average years of experiences of about 22 years.  Their knowledge about IT and specific vertical niches is another competitive advantage.

Strong Balance Sheet and Expected Steady Build Up in Cash Position

EDGW has a low-risk, “Ft. Knox” balance sheet.  EDGW’s balance sheet at 6/30/14 had net cash of $22m or 25% of market cap.  EDGW was able to remain cash flow breakeven even in the very depressed economic conditions of 2008-9.  We expect EDGW’s net cash position to continue to build up at $8m-$10m per year, assuming no expenditures for share repurchases, dividends, or niche acquisitions.  We believe the continued build up in net cash will highlight EDGW’s attractive business model and could result in an improved valuation.

High ROIC Business Model

EDGW’s service business model generates a high ROIC.  Accounts receivable are significantly balanced by accrued expenses.  This reduces working capital requirements.  Capital expenditures are minimal.  EDGW has an ROIC of 50%+ based on FCF divided by the sum of net working capital plus net PPE.  This ratio considers the tangible assets required to operate the business.  EDGW does not require much capital to run its business model.  Management believes that adjusted EBITDA (about $10m on LTM basis) is a good proxy for FCF.

Industry Consolidation Prospects

There are larger industry players that are well-capitalized (see Comparables below) and highly acquisitive in terms of adding smaller companies to increase their client and service portfolios.  We believe one or more of these IT industry players could be attracted to EDGW as a result of its diverse and high-quality customer base, its strong relationships with software industry powerhouse players Oracle and Microsoft, and experienced and talented base of employee consultants who are highly skilled at implementing key software for end user clients.

2014 Results To Date Provide Solid Momentum into 2015

The Company’s results for six months ended June 2014 were solid, with total revenue up 11% and adjusted EBITDA of $4.7m, or about 8.3% of total revenues, for six months of 2014 versus $2.6m, or about 5.1% of total revenues, in prior year.

We believe the positive momentum in first half of 2014 may carry over into the rest of 2014 and into 2015.   We believe this positive momentum, driven by new business wins, a strong pipeline, well controlled operating expenses, and strong utilization ratios could continue over the next few years.

Management has tightly controlled operating expenses and driven higher utilization of consultants to increase gross margin dollars.  New business efforts have also been effective, helping to drive improved revenues for six months of 2014.  We believe the current software upgrade cycle is still relatively early and EDGW could realize multiple additional years of solid growth as customers upgrade their software systems to reduce costs, realize efficiencies, and help drive sales.

Solid Shareholder Value Enhancement Strategy Over Next Few Years

We think EDGW has a solid strategy to enhance shareholder value over the next couple of years with multiple potential drivers.  EDGW has a goal of high single digit organic growth over the next few years.  These include: 1) organic revenue growth from supported by an improving market and strong new business activity; 2) increased utilization of consultants to drive increases in service revenue (every 1% change in utilization represents about $1.2m change in service revenue); 3) higher annualized service revenue per consultant; 4) vertical specific IP software enhancements which are proprietary; and 5) strategic relationships to add technical expertise or geographic capabilities.  EDGW’s shift towards more profitable services offerings – from classic consulting to EPM and ERP product consulting has driven increases in average revenue per consultant over the past several years.

EDGW’s financial goals in the near term include: 1) high single digit organic service revenue growth on annual basis; 2) continuing balancing of new hires, driving utilization improvement; 3) continue to generate strong free cash flow; and 4) maintain a strong balance sheet for “tuck-in” acquisitions, internal growth initiatives, and stock repurchases.

Excellent Potential for Share Repurchase or Dividends

EDGW has not repurchased significant shares to date but, as its balance sheet continues to build up net cash, we believe a major share repurchase program and/or dividend will be more seriously considered, and would expect major shareholders to push for these types of actions.  Management recently renewed their $23m share repurchase program.  EDGW’s strong cash generation and excess cash balance sheet give management multiple levers to drive shareholder value.

Pension Costs

EDGW does not have significant pension obligations which it has to fund.

Conclusion and Target Price

Based on 10x our adjusted EBITDA estimate of $12m in 2016 and a projected $35m net cash position at year-end 2016, we believe EDGW could trade for a market value of close to $155m or about $13 per share versus $7 per share today (+85%).  We believe a 10x adjusted EBITDA multiple is not unreasonable, given the non-capital intensive nature of EDGW’s business model and the current low interest rate environment.  Further, we believe EDGW’s high ROIC IT services business, its powerful vendor partner relationships, and its diversified customer base could prove attractive to a strategic or financial acquirer.